Editor: Greg A. Fairbanks, J.D., LL.M.
The quest to properly report revenue for federal income tax purposes continues as 2021 tax filings will provide yet another opportunity for taxpayers to assess and adjust their revenue recognition methods. In 2018, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended the Sec. 451 statutory provisions, which substantially modified long-standing revenue recognition rules. Further, late in 2020, the IRS released final revenue recognition regulations under Sec. 451 that provided much-needed clarity on how taxpayers should apply the new Sec. 451 provisions. Lastly, in 2021, Treasury and the IRS released Rev. Proc. 2021-34, providing the required procedural guidance needed for taxpayers to comply with Sec. 451 and the final revenue recognition regulations issued thereunder.
Changes to revenue recognition
The new revenue recognition rules provided under the TCJA contained many significant changes for taxpayers. Among such changes are the following:
- Sec. 451(b) effectively modified the "all-events test" to require accrual-method taxpayers to recognize revenue at the earliest of when revenue is due, earned, received, or recognized in an applicable financial statement (later termed the AFS income-inclusion rule in the final regulations). This is significant, as the manner in which revenue is recognized for financial statement purposes was also modified under FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers, and IFRS 15 (the new standards). These new financial statement rules often resulted in an acceleration of revenue, which, in turn, could result in an acceleration of taxable income. Lastly, it is important to note that Sec. 451(b) should not be construed as simple book/tax conformity because application of the provision is much more complicated than a conformity rule.
- Sec. 451(c) codified and modified the deferral method for advance payments permitted under Rev. Proc. 2004-34. It is important to note that the final regulations obsolete Rev. Proc. 2004-34 for tax years beginning on or after Jan. 1, 2021. As such, taxpayers need to assess the application of Sec. 451(c), and the regulations thereunder, to their particular facts and circumstances to determine their ability to defer revenue recognition relating to advance payments.
As one might expect, the new provisions provided under the TCJA left taxpayers with many questions relating to their proper application. In addition, taxpayers with newfound acceleration of taxable income under Sec. 451(b) were looking for some form of relief from the AFS income-inclusion rule. Treasury responded to taxpayers' concerns by issuing final regulations under Sec. 451 at the end of 2020. These regulations are generally required to be implemented by taxpayers no later than tax years beginning on or after Jan. 1, 2021.
Perhaps two of the most significant opportunities are contained in Regs. Sec. 1.451-3 and relate to contractual enforceable right provisions and an optional cost-of-goods offset.
- Enforceable right: Under the enforceable-right rule, taxpayers may exclude from taxable income (and, accordingly, Sec. 451(b) recognition) amounts to which the taxpayer does not have an enforceable right to recover if the taxpayer's customer were to terminate the contract to which the income relates on the last day of the tax year. The determination of whether the taxpayer has an enforceable right is governed by the contract and applicable federal, state, or international law. As such, taxpayers need to possess a thorough understanding of the facts surrounding a transaction as well as how federal, state, or international law is applied to the contractual terms of that transaction. Accordingly, an analysis of enforceable-right provisions can prove burdensome and time-consuming for some taxpayers. Taxpayers that do not want to undertake the analysis each year may instead adopt the alternative method, which does not make the annual adjustments to AFS revenue for the enforceable-right rule.
- Cost offset: In the case of certain types of transactions involving the production of goods over a period of time, financial statement reporting may now recognize (accelerate) the income and the related production costs over time as the entity produces the goods, rather than recognizing both at the point in time that the goods are delivered to the customer. Pursuant to the AFS income-inclusion rule, tax recognition of this production income may be accelerated such that tax recognition will match the book timing for revenue recognition. However, the related cost of goods sold (COGS) may not be accelerated for tax purposes. As a result, there can be a mismatching of revenue and COGS for tax purposes. In response to taxpayer concerns over this potential mismatch, Treasury provided the cost-offset method in the final regulations. The method does not provide a COGS deduction when goods are produced over a period of time and an amount is accelerated into income under the AFS income-inclusion rule. Instead, the final regulations allow a taxpayer to reduce the amount of revenue it would otherwise be required to include under the AFS income-inclusion rule for the tax year by the cost of goods related to the item of inventory for the tax year.
Under both the AFS income-inclusion rule and the alternative method, Regs. Sec. 1.451-3 requires three additional adjustments to AFS revenue for purposes of Sec. 451(b): increase revenue for any reductions taken into account in the financial statements for liabilities properly accounted for under Sec. 461 or as COGS (however, see the cost-offset method above); increase revenue for amounts that were anticipated to be in dispute or uncollectible; and decrease revenue for increases to the transaction price as a result of a significant financing component.
As indicated above, Sec. 451(c), as supported by the final regulations (Regs. Sec. 1.451-8), codifies and modifies Rev. Proc. 2004-34 such that certain advance payments are eligible for the deferral method of accounting. To qualify as an advance payment, the payment must be eligible to be included in income in the year of receipt, and all or a portion of the payment must be reflected in the taxpayer's AFS in a year subsequent to the year of receipt. Further, the payments may only relate to certain items such as goods, services, the use of intellectual property, computer software, eligible gift cards, certain warranty contracts, subscriptions, memberships, and the occupancy or use of property ancillary to the provision of services.
Taxpayers with contracts allocated to multiple performance obligations under the new standards should examine the treatment of revenue attributable to each performance obligation to determine the potential existence of an advance payment eligible for deferral. For example, taxpayers offering loyalty programs may have a portion of their sales allocated to the loyalty points provided to a customer under the program. The regulations indicate that such an allocation may result in a deferral opportunity for the loyalty program revenue.
Implementation of the foregoing rules may prove to be almost as complex as the rules themselves. The IRS released Rev. Proc. 2021-34, which modifies Rev. Proc. 2019-43, to provide procedures to obtain automatic consent from the IRS to change methods of accounting to comply with the final rules under Regs. Secs. 1.451-3 and 1.451-8. The revenue procedure itself is over 70 pages and contains extensive details relating to the multiple method changes available, concurrent filings, streamlined method change procedure, audit protection, netting of Sec. 481(a) adjustments, and waiver of the ineligibility rule triggered by changes in the prior five years. As such, taxpayers must carefully examine the revenue procedure for proper application of the final regulations, as it is nuance-driven and, therefore, creates the possibility for technical "foot faults" in its application. Some of the more significant procedural rules relate to the following:
- The procedures and rules included therein are effective for all Forms 3115, Application for Change in Accounting Method, filed with the IRS on or after Aug. 12, 2021.
- Streamlined method change procedures are available to taxpayers implementing certain methods provided for in the final regulations that compute zero Sec. 481(a) adjustment. Such procedures do not require a taxpayer to complete and attach a Form 3115 or statement to the tax return.
- Audit protection is generally provided for all Forms 3115 filed under the revenue procedure. However, taxpayers using the streamlined method change procedures will not receive audit protection.
- The five-year scope limitation under Section 5.01(f) of Rev. Proc. 2015-13 (which limits a taxpayer's ability to make automatic method changes if the taxpayer made a change for the same item in the prior five years) is waived for a taxpayer's early adoption year or, if there was no early adoption, for the taxpayer's first tax year beginning on or after Jan. 1, 2021. Thus, it appears that the five-year waiver may only be used once by a taxpayer when applying the final regulations.
- The revenue procedure adds seven new automatic method changes to the current list of automatic changes in Rev. Proc. 2019-43 and modifies several others. Taxpayers should review those modifications for any pending method changes and make adjustments to comply as necessary.
Implementing the final regulations
The following examples illustrate some of the decisions that taxpayers will need to make during implementation of the final regulations using the procedural rules of Rev. Proc. 2021-34. For all examples it is assumed that the taxpayer is an accrual-method taxpayer with an AFS and is on a calendar year end for both tax and AFS.
Example 1: In December 2021, Taxpayer enters into a contract with its customer to manufacture and deliver goods in 2023, with a total contract price of $100, and receives an advance payment of $40. In its AFS, Taxpayer does not report any revenue in 2021 and will report the entire $100 in its 2023 AFS, the year of delivery. Taxpayer is currently on a permissible one-year deferral method under Rev. Proc. 2004-34.
Analysis: Under its present method of accounting, Taxpayer would recognize no revenue for tax purposes in 2021 because it did not recognize any in its AFS. However, the entire $40 advance payment will be recognized in taxable income in 2022. Taxpayer may change to use the one-year deferral method under the final regulations, and it would have the same taxable income impact as under its present method of deferral. Alternatively, Taxpayer may change to use the full-inclusion method under the automatic procedures, and if it does, it would recognize the entire advance payment in its 2021 taxable income.
Observations: Whether Taxpayer decides to change to the full-inclusion method or stay on the deferral method, it is required to implement the final regulations in 2021 and must change from its present method of accounting. However, if Taxpayer decides to implement the deferral method under the final regulations, it may be eligible to do so under the streamlined procedures in Rev. Proc. 2021-34 because the Sec. 481(a) adjustment would be $0. Use of the streamlined procedures is optional, and Taxpayer may instead choose to make the change by filing a Form 3115. Taxpayer should be aware that if it uses the streamlined procedures, it does not receive audit protection for prior years. While not directly the subject of this example, Taxpayer is also incurring costs to which it could apply the advance payment cost-offset method (similar to Example 3), which would create an additional deferral of income.
Example 2: In July 2021, Taxpayer enters into a contract with its customer to provide professional services with a total contract price of $100, billable upon delivery, with an estimated cost to deliver of $60. The terms and conditions of the contract provide that if the customer cancels the contract, the customer is only required to pay Taxpayer the amount that it spent or incurred through the cancellation date. In its AFS, Taxpayer reports revenue from the contract over time. Additionally, Taxpayer has determined that it generally only collects 90% of the contract value from this type of contract and reduces its transaction price by 10% when computing its AFS revenue. Taxpayer incurs $30 of costs on the contract in 2021 and computes its AFS revenue to be $45, which is the total contract price, less the amount anticipated to be uncollectible, multiplied by the ratio of costs incurred over estimated total costs to deliver (($100 − $10) × ($30 ÷ $60)). For tax purposes, Taxpayer currently recognizes revenue equal to its AFS.
Analysis: Under the final regulations, Taxpayer may choose to use either the AFS income-inclusion rule or the alternative method to determine the amount of revenue to accelerate as AFS revenue under Sec. 451(b). If it chooses to use the general rule, then Taxpayer would increase the transaction price by the amount anticipated to be uncollectible, and it would reduce the transaction price by the amount to which it does not have an enforceable right. In this case, because the customer could cancel the contract on the last day of the year and would only be required to reimburse the $30, Taxpayer would adjust its 2021 taxable income to be $30 ($45 + $5 — $20) and have a favorable book-tax adjustment of $15. If Taxpayer instead implements the final regulations using the alternative method, it will only make an adjustment for the amount anticipated to be uncollectible and would recognize revenue of $50 for tax purposes in 2021 ($45 + $5) and an unfavorable book-tax adjustment of $5.
Observations: Taxpayer has a decision to make when implementing the final regulations: It may use either the AFS income-inclusion rule or the alternative method to determine its AFS revenue inclusion. On the surface, using the AFS income-inclusion rule and reducing revenue based on the enforceable rights adjustment may be beneficial (depending upon other tax attributes such as NOLs, credits, etc.) for Taxpayer because it results in lower revenue and taxable income. However, that benefit comes with the requirement that Taxpayer evaluate each contract at the end of each year to determine the amount to which it has an enforceable right — a challenging task if contracts are customized or voluminous. Taxpayer may find that the relative simplicity of the alternative method may be preferable, even though it is not the most tax-advantaged method. Under either scenario, Taxpayer will be required to make adjustments to AFS revenue to increase the transaction price by the amounts anticipated to be uncollectible.
Example 3: In 2021, Taxpayer enters into a contract with its customer to manufacture and deliver goods with a total contract price of $100, billable upon delivery. In its AFS, Taxpayer recognizes $11 of costs associated with the contract in 2021 and $47 in 2022. Taxpayer includes $20 in its AFS revenue in 2021. Taxpayer properly applies its inventory tax accounting methods and incurs $12 of costs for tax purposes in 2021 and $48 in 2022. Taxpayer implements the final regulations and chooses to adopt the cost-offset method beginning in 2021.
Analysis: Taxpayer reduces the $20 AFS inclusion amount by the $12 cost-of-goods-in-progress offset, which results in the recognition of $8 of revenue for tax purposes in 2021. Taxpayer is not entitled to a COGS deduction for tax purposes in 2021 because it retains title to the goods in 2021. Taxpayer receives the $100 upon delivery of the goods in 2022. This amount is reduced by the prior (2021) tax inclusion amount of $8, which results in the recognition of $92 of revenue for tax purposes in 2022. Taxpayer is entitled to a $60 COGS deduction for tax purposes in 2022, as ownership of the goods passed to the customer in 2022. The result to Taxpayer in 2022 is gross income for tax purposes of $32.
Observations: By electing to use the cost-offset method, Taxpayer was able to defer revenue of $12 (the cost-of-goods-in-progress offset) to 2022, which is a favorable outcome and mirrors closely (but not exactly) the computation of income for AFS purposes. However, the cost-offset method must be applied to all items of income eligible for the method in the taxpayer's trade or business and allocated on an item-by-item basis. Such computations may be difficult or time-consuming and even costly to Taxpayer. The use of the cost-offset method is optional, so Taxpayer may choose to simply recognize $20 of revenue in 2021, without the offset, to simplify its tax calculations.
The final regulations and associated procedural guidance are intricate and contain many options and choices for taxpayers, as well as traps for the unwary. With the current procedural guidance, most taxpayers have one chance in the year beginning on or after Jan. 1, 2021, to complete the analysis and take steps such as automatic method changes. Beginning a detailed analysis early will allow taxpayers the time and flexibility to make those choices and to perform complex computations or make required tax filings.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.